Trying to figure out what to say after this past week is a challenge, so we asked various friends and family what they thought. In the wake of the Madoff financial scandal and the revelations of the carnage from same, one spouse merely replied: "Will Wall Street ever again have credibility? Write about that."

The Prime Model

The road back to credibility for the US financial system starts with hard choices. Last week, Sanderson State Bank, Sanderson, TX, was closed by the Texas Department of Banking. The FDIC was named receiver and entered into a purchase and assumption agreement with The Pecos County State Bank of Fort Stockton, TX, to assume all of Sanderson State Bank's deposits, including those that exceeded the deposit insurance limit.

At the time of the closure, $38 million asset Sanderson had an overall score of 21.0 vs. the industry average of 1.5 on the IRA Bank Stress Index, equaling an "F" rating on IRA's new quintile based ratings methodology. Sanderson had displayed above-peer risk scores for some time, while its operational efficiency was likewise below peer. At the time of the closure, Sanderson had 8.8% leverage, again illustrating the approach by state regulators and the FDIC of targeting institutions for resolution before they become visibly insolvent.

Pecos County is a strong institution with an overall score of 0.8 vs. industry average of 1.5 on the IRA Bank Stress Index. That's an "A+" rating in IRA's new quintile based ratings methodology we just released. Keep up the good work Pecos.

In Georgia likewise the triage process continues. The $560 million asset Haven Trust Bank, Duluth, GA, was closed last week by the Georgia Department of Banking and Finance, and the FDIC was named receiver. The FDIC entered into a purchase and assumption agreement with Branch Banking & Trust, lead unit of BBT (NYSE:BBT), to assume all of Haven Trust's deposits, including those that exceeded the insurance limit.

The FDIC estimates that the cost to the Deposit Insurance Fund will be $200 million. Haven had a score of 21.5 on the IRA Bank Stress Index vs. the industry average of 1.5 on the IRA Bank Stress Index, equaling an "F" rating on IRA's new quintile based ratings methodology. A 21.5 is a bit more than one order of magnitude above the peer benchmark mean for the Stress Index of 1.5, so once again it is seen that a Stress Score greater than 10 is dangerous territory for banks.

The Bailout Model

Note the courageous stance taken at the local level with smaller institutions, where the state regulators and the FDIC work together to put the good assets into strong hands, thereby improving the overall stability of the system and in particular its ability to re-leverage and provide new credit to the private economy. It's not a happy task to resolve a bank and wipe-out bank shareholders, but that purifying process of closure and resolution by the FDIC enables new investors with new capital to make the failed banks assets productive and work for the entire economy.

Then we have the example of the cowardly bailout model embraced by Treasury Secretary Designate Tim Geithner, Secretary of Treasury Hank Paulson, and the Federal Reserve Board in Washington. The rescue and subsidy of the Bear Stearns shareholders and creditors, as well as the ongoing and expanding support for AIG (NYSE:AIG) and dozens of other borrowers, are all examples of not dealing with the problem. Indeed, the Geithner/Paulson bailout model ensures a deep recession in the US and globally.

And Fed officials, in their myopia and political naďveté, are refusing to disclose to the public the details of the loans or even who the borrowers are! Hello? Memo to Bernanke and Geithner: The Fed is now the center of a three-ring political circus. The days when Fed operations could be shielded from full public disclosure, at least equal to the standard of openness mandated by law with respect to the TARP, are over.

The Fed needs to get ahead of the issues raised by the Bloomberg News lawsuit seeking to force the central bank to disclose the identity of entities that have received Fed loans.  The mounting congressional inquiry regarding executive compensation at AIG is just the tip of the iceberg of a political scandal that could engulf the Fed and destroy what remains of the central bank's credibility. Rep. Elijah E. Cummings (D-MD) claims of a "pattern of deception" at AIG may soon be made against the Fed itself unless Bernake et al "come clean."

As we noted in a comment in The Times of London, neither Geithner nor Bernanke have any authority legal to spend tax dollars, but that is precisely what the bailout model of political economy embraced by the Fed entails - expenditure without authorization nor deliberation by Congress. Some or all are of the loans made by the Fed could result in losses to the central bank, losses that must come out of the of revenues due to the Treasury. The Congress may even be forced to appropriate new capital for the reserve banks due to losses generated by the Geithner/Paulson bailout model.

The open bank support for Citigroup (NYSE:C) is another case in point of the bailout model of political economy. What is the long-term plan for C? Does the Fed and/or OCC have a road map for how this open bank assistance will be concluded?

Q: Do you suppose that Bob Rubin finally will step down from C's board before the bank is placed into a resolution by the FDIC? Wouldn't it be remarkable if Rubin and the other Friends of Barack Obama on the C board of directors ended up as targets in an FDIC enforcement action after the Deposit Insurance Fund takes a loss on C? By law, when the FDIC takes a loss on a resolution and apparent malfeasance is involved, the bank directors usually face an enforcement action.

Instead of hiding areas of weakness in the financial system from scrutiny, the Obama Administration should demand that C be broken up and sold, that AIG be placed into bankruptcy, and that any banks/dealers left insolvent by AIG's filing should be sold or resolved as well, including Goldman Sachs (NYSE:GS).

Part of the reason we put the role of the FDIC and local regulators in such stark contrast to the loathsome and conflicted behavior we see in Washington and on Wall Street is that the Congress is rapidly approaching a crossroads when it comes to the next phase in the bailout, namely where and how to apply the further $350 billion in funds to help stabilize the banking system and then expand the aggregate supply of credit to support an economic rebound.

The good news is that the Fed's efforts to provide liquidity to the markets has stabilized the situation with respect to most financial institutions. This calm allows policy makers and regulators to make some informed judgments about the portions of the financial system that can be recapitalized and rebuilt, and those which should be resolved. We then need to move forward purposefully dealing with these two tasks, rebuilding and resolution.

As Eric Hovde discussed in our recent interview ('On the Prime Solution: Interview with Eric Hovde', December 11, 2008), the place where the Congress needs to put the next $350 billion and more is supporting the real economy and the portion of the US banking system that can support risk and create new loans to support private business. We're not big fans of a bailout for the automakers, but in relative terms, literally giving away money to Detroit is better for the economy than "investing" a dollar more of further public funds in the large zombie money center banks like C and JPMorgan Chase (NYSE:JPM).

As and when these two institutions again become capital constrained, in our view sometime next year, the FDIC should take them over, appoint new boards and then conduct an orderly liquidation. But if Barack Obama and the Congress want to get the US economy off its knees before the next election, then they must act more quickly and decisively when it comes to questions of solvency.

Strong banks and companies can support a strong economy, but zombie banks with balance sheets polluted by OTC derivatives, subprime debt and other toxic waste are a drag on the taxpayer and the economy. The prime solution of driving the bad banks out of the system means a quicker recovery from the spreading economic malaise.

But don't bet on Barack Obama taking such a road until he gets Bob Rubin, Larry Summers et al off his back. Until these architects of the policies which led to the current misery are sent packing, Barack Obama's recovery plan will have no credibility.

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